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Doug Kass has appeared numerous times in Barron's, having penned his first guest column for us in 1992, on the case for shorting Marvel Comics stock. Those who want more of his humorous and distinctive views on stocks and companies can follow his blog on seabreezepartners.net or watch his frequent TV appearances. A onetime Nader's raider (he wrote a book about Citibank with consumer advocate Ralph Nader), Kass, 63 years old, invested money for such firms as Omega Advisors, Glickenhaus & Co., and Putnam Management before founding his firm in 1997. In his latest Barron's interview, the former housing analyst talks about the recovery in housing and why he's shorting
Goldman Sachs.
GS -0.6096500310623317%Goldman Sachs Group Inc.U.S.: NYSEUSD239.978
-1.472-0.6096500310623317%
/Date(1481307502757-0600)/
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:
2828506
P/E Ratio
19.105976095617528Market Cap
96012346653.2929
Dividend Yield
1.0843273000250229% Rev. per Employee
959701More quote details and news »GSinYour ValueYour ChangeShort position

Barron's: You recently cut your long exposure. Why?

Kass: I've been cautious for two years, reflecting the unique structural challenges and head winds that have produced subpar jobs growth and tentative profits growth. Nothing has transpired to make me change my view. Four factors form the potential for a toxic cocktail. First, global growth is slowing. The outlook for corporate profits is worsening, the U.S. is experiencing the third pause in a subpar recovery that began in '08, the euro zone is in recession, and important growth markets like China and India are sputtering. Second, monetary easing is losing its effectiveness. Responsible fiscal policy now holds the key to economic success. Third, the U.S. and euro-zone leaders remain inert and dysfunctional, divided on ideological grounds. At the beginning of the year, I hoped concessions would be made. That hasn't happened. As we move closer to the November elections and the fiscal cliff, election paralysis has set in. Our leaders are acting like grade-schoolers. The European leaders are even less focused on real change. The recent Brussels summit provided baby steps, not bold initiatives. Finally, we have a negative feedback loop hurting confidence in the markets. The potential exists for a further downward spiral in the months ahead.

What happens to the market?

I look at four basic outcomes. First, economic re-acceleration above consensus, which I give a 5% probability. Second, below-consensus growth, a 40% probability. Third, a muddle-through, a 50% probability. Fourth is a recession, precipitated by loss of business and consumer confidence, a 5% probability. This is the worst case. The Democrats regain the White House and the Senate, the Republicans regain the House, and the rancor of partisanship during the debt-ceiling deliberations gives us a further deterioration in confidence. The housing market seizes up. The fiscal cliff is not remedied or addressed. QE3 is instituted, but fails to contain the weakness, because it is pushing on a string. The European recession deepens. We have hard landings in China, in India. Then next year's Standard & Poor's 500 earnings are materially reduced from an expected $116 to $80, and stocks have a huge correction.

Most positive case: We whittle the cliff, or the gap between currently mandated tax increases and spending cuts, to $150 billion from $500 billion, which only subtracts a half-percent from real GDP next year. In the muddle-through scenario, it goes to $275 billion. The below-consensus growth scenario, it goes to $350 billion. Worst case: We don't whittle it down at all.

If you permit me a metaphor, the market is like a bathtub. Various investors are sloshing around, causing the tub to consistently lose water. There are no inflows to replenish the water. The only active bathers are high-frequency traders doing a disproportionate amount of splashing. They are wild, unpredictable, and don't use soap very often. I suspect the S&P 500 is range-bound between 1280 and 1410 as far as the eye can see, but we face a bias to the downside over the balance of the year.

Yet you recently quoted the late Barton Biggs saying: "When your partner is deeply distressed, depressed, and in a dark mood and offers to sell his share of the business at a huge discount, you should buy it."

Barton was talking about sentiment. Classically, lousy sentiment implies good market value. I'm not so sure that should apply going forward. Since 2007, $400 billion of outflows by individual investors have come out of domestic equity funds, and they committed nearly a trillion dollars to no- or low-yielding fixed-income funds.

Sentiment and expectations are low for a number of reasons. First, a decade of underperformance. Second, two large drawdowns of stocks in the past decade—from 2000 to 2002 and from 2008 to 2009. Three, what I call the screwflation of the middle class, where the average Joe sees stagnating income, while the cost of necessities rises. Buying stocks is low on his list of priorities. Fourth, the flash crash in 2010 scared the crap out of everyone, and we still don't know the reason for it.

Today's trading is dominated by robots and algorithms. They don't display remorse or conscience. They can't read a balance sheet or an income statement. They lead to exaggerated market moves that further alienate hedge funds and retail investors. How can sentiment measures take that into account? Finally, all these market scandals and loss of investor money with Bernie Madoff, Allen Stanford, MF Global, and now Peregrine Financial are important.

Let's have some investment ideas. You are short the brokers. Why?

A few basic reasons. The business model has been disrupted. There will be far less capital-markets activity in the future, in investment banking, proprietary trading, institutional and investment advisory, where competition will be heated. The prop-trading profile wasn't helped by the
JPMorganJPM -0.6402725563909775%JPMorgan Chase & Co.U.S.: NYSEUSD84.575
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6634171
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14.601724137931035Market Cap
304581834359.245
Dividend Yield
2.2670917463691107% Rev. per Employee
421457More quote details and news »JPMinYour ValueYour ChangeShort position
[ticker: JPM] trading gaffe or the recent revelation that
BarclaysBCS -2.7522935779816513%Barclays PLC ADRU.S.: NYSEUSD11.66
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50890266292.1064
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1.806535500427716% Rev. per Employee
239050More quote details and news »BCSinYour ValueYour ChangeShort position
[BCS] and others manipulated Libor. The next three to four years will be disruptive. Second, on a short-term cyclical basis, industry conditions are very weak. Third, adverse secular changes will translate into considerably lower industry returns on invested capital and profits. And restoring the run rate of return on equity yields more questions than it answers.

If we go back and look at a composite of JPMorgan,
Bank of AmericaBAC 0.02178649237472767%Bank of America Corp.U.S.: NYSEUSD22.955
0.0050.02178649237472767%
/Date(1481307520419-0600)/
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19.14547728220092Market Cap
232342244198.49
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1.3063357282821686% Rev. per Employee
432244More quote details and news »BACinYour ValueYour ChangeShort position
[BAC], Citigroup [C] and
Morgan StanleyMS 0.08031206975676916%Morgan StanleyU.S.: NYSEUSD43.615
0.0350.08031206975676916%
/Date(1481307513843-0600)/
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6647223
P/E Ratio
17.464Market Cap
81617544566.9331
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1.832340815391663% Rev. per Employee
642534More quote details and news »MSinYour ValueYour ChangeShort position
[MS], you'll see that back in '07, their return on tangible capital was around 25%. Last year, it went down to 8% because return on equity was cut in half from regulatory and capital-rule changes; there were lower capital-market volumes, and higher expenses.

I can't see that 8% going materially higher, and I would say it will range between 8% and 12%. It will still be cut by further changes in leverage ratios. We'll probably get a recovery in capital-market volumes at some point. We'll probably get higher rates. We'll get regulatory revenue mitigation, like changing pricing, adding charges for checking accounts and debit card use. We'll get lower expenses. That will contribute to a modest net gain from the 8% returns. So trade the sector, don't invest in it.

I believe it's a value trap because of the cyclical and secular influences. My price target is $80 a share. You can see the secular change in return reflected in the sorts of business they have begun to ramp up, with a new business unit that will lend more directly to corporations, and expanding investment management.

The swashbuckling style that created 25% to 30% returns from the business of proprietary trading are being buffeted by a wave of new regulations, market turmoil, bad PR. They are reshaping to a lower margin, lower valuation sort of business. I have it in a paired trade that is long
Oaktree CapitalOAK 0.12531328320802004%Oaktree Capital Group LLC UnU.S.: NYSEUSD39.95
0.050.12531328320802004%
/Date(1481307451027-0600)/
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:
219496
P/E Ratio
16.835443037974684Market Cap
2510268754.44641
Dividend Yield
6.516290726817043% Rev. per Employee
437368More quote details and news »OAKinYour ValueYour ChangeShort position
[OAK], a defensive alternative-asset manager that trades at a discount to the others as measured by equity capitalization to assets under management. They are conservatively run and have historically been protective of capital in difficult market backdrops. They have the best management and are led by a hero of mine, Howard Marks, who wrote a great book called The Most Important Thing.

The two beneficiaries are Altisource and Ocwen. Altisource now trades at $76. I still like it as much. It provides services in terms of asset recovery of defaulted mortgages. It is one of the few companies I know that is experiencing 45% to 50% revenue growth and doubling earnings in a tepid environment.

Ocwen is the largest subprime-mortgage servicer in the U.S. Banks are disaggregating themselves from the mortgage-servicing business, which tends to be capital-intensive and is now considered a noncore business.

In the past year, Ocwen purchased nonprime mortgage-servicing portfolios from Goldman Sachs, Morgan Stanley, and Barclays. Its platform now has close to $150 billion of servicing assets in its portfolio. When the loans default, the business goes to Altisource. Altisource will probably earn in excess of $5 a share this year. Ocwen will earn close to $2.50. I think Altisource will trade in excess of par, and in the fullness of time– i.e., in the next year or two–Ocwen can go up as much as 50%.

For-profit education is a longstanding short theme for you.

Private education is a very poor value proposition. There is substantially growing competition from nonprofit universities that have already begun to tease customers by offering free courses. Consensus estimates of earnings are dreams that will turn into nightmares. The stocks have been halved. My largest and favorite short in for-profit education is
Grand Canyon EducationLOPE -0.37841395195788086%Grand Canyon Education Inc.U.S.: NasdaqUSD60.55
-0.23-0.37841395195788086%
/Date(1481307452304-0600)/
Volume (Delayed 15m)
:
180826
P/E Ratio
20.62372881355932Market Cap
2876899693.34961
Dividend Yield
N/ARev. per Employee
231407More quote details and news »LOPEinYour ValueYour ChangeShort position
[LOPE]. It trades at $17, and my price target is $8 to $10.

Anything else?

If I want to be long domestic housing-related stocks like Altisource and Ocwen, it follows that I want to be short companies exposed to the disarray in Europe and the prospects for an extended period of slow growth.

The first is
American ExpressAXP -0.6674676278200508%American Express Co.U.S.: NYSEUSD74.41
-0.5-0.6674676278200508%
/Date(1481307520222-0600)/
Volume (Delayed 15m)
:
978040
P/E Ratio
13.184397163120567Market Cap
68561755767.5354
Dividend Yield
1.7213555675094137% Rev. per Employee
626953More quote details and news »AXPinYour ValueYour ChangeShort position
[AXP], which missed in the second quarter. The rate of growth in its bill business dropped by half in that quarter from the first, principally because of exposure in Europe. Earnings estimates face a geographic head wind. There's also a competitive head wind, from offerings like the JPMorgan Sapphire card. Even Goldman Sachs just started a consumer bank that will be a competitive threat to American Express.

The second is
Henry ScheinHSIC 0.7445323406235458%Henry Schein Inc.U.S.: NasdaqUSD151.55
1.120.7445323406235458%
/Date(1481307509764-0600)/
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:
145803
P/E Ratio
25.17109634551495Market Cap
12108260136.4795
Dividend Yield
N/ARev. per Employee
594824More quote details and news »HSICinYour ValueYour ChangeShort position
[HSIC], one of the largest distributors of dental equipment, both consumables and heavy equipment like X-ray machines. It also has a veterinary business. The valuation is relatively high. I think Henry Schein will guide lower in the second half because 35% of its revenue base is non-U.S. Of that, probably 75% is in Europe. It is a serial acquirer that has made probably 50 acquisitions in the past five years. Also, I see a more difficult environment for the consumer in the years ahead as deleveraging continues. A lot of dental expenses are postponable and discretionary. The stock is virtually at its all-time high.

Finally, my favorite short of the next decade is the U.S. bond market, for those that possess deep enough pockets, have the fortitude and the patience. I am long
ProShares UltraShort 20+ Year TreasuryTBT 2.597717892692401%ProShares UltraShort 20+ Year TreasuryU.S.: NYSE Arca42.26
1.072.597717892692401%
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N/AMore quote details and news »TBTinYour ValueYour ChangeShort position
[TBT], which is the inverse, double-short bond ETF. Over the past 2½ years, bonds have achieved a near 60% total return. A remarkable feature is the consistency of positive returns and the absence of many drawdown years of consequence. Nevertheless, they should be viewed as a return-free asset class that is very risky. The 10-year yields under 1.5%, less than half the yield during the recessions in 2001 and 2008. That means I am paying over 65 times earnings for a 10-year-bond, a rich price even by Amazon's or LinkedIn's standards.

A taxable investor who buys the 10-year pays about 40% to Uncle Sam in taxes. So his after-tax yield is 0.9%. The inflation rate is 2%. So the investor is getting a rather large negative return. A diminution of the flight to safety is a first possible disruptive factor.

Other factors that form the basis for my bond short are that the muddle-through economy might gain speed, that Fed policy stays on hold, that inflation will ultimately rise, that housing is embarking on a durable recovery, that ultimately there will be a large reallocation of investment out of bonds into stocks, and that U.S. fiscal imbalances are not being addressed, so bond vigilantes who will demand higher yields are likely to appear.

Every year, you predict potential surprises for the market. What's the biggest one for the second half?

That Obama wins by a substantial plurality and that the Democrats regain control of the Senate and don't have control of the House. The market feels that Romney is far more pro-market than Obama. In this case, I think you could have a further drop in valuations, beyond what you might expect from a difficult second half for corporate profits.

About 70% of the companies that reported earnings so far have beaten expectations. But 65% have missed the top line on sales. If the election result means that Congress becomes more dysfunctional, the market is in big trouble.